A very interesting back story is developing not too far away from the slew of financial carnage now making headlines around the world, and it quite clearly is pointing the proximate cause for our economic armaggedon at the feet of the current resident of 1600 Pennsylvaina Avenue: George Walker Bush.
Many folks are already pointing the finger to the lack of oversight and loosened regulations, and the SEC is getting its fair share of the blame, but now we have a real bonafide inside source who can spell it all out in black and white.
The source for this story is one former SEC official, Lee Pickard, and his story has appeared in of all places- the New York Sun:
Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers
By JULIE SATOW, September 18, 2008
The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.
The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults...
Pickard’s very clear conclusion:
"They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up."
In elucidating the details of this mechanism- it is explained that
The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower...
This alternative approach, which all five broker-dealers that qualified — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley — voluntarily joined, altered the way the SEC measured their capital. Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based model for calculating risk that led to a much smaller discount.
So you see now why there is such a mess- the Bush administration approved the increased risk! And the scale of the allowable increase of risk was much higher than double, and it was even higher than triple! - it was in fact increased by a factor of well over 3.33 to 1!!!
This story is also currently heating up a very hot morning entry on Barry Ritholz’s ‘Big Picture:
How SEC Regulatory Exemptions Helped Lead to Collapse
And Barry, who is also briefly quoted in the Sun article, concludes with this extremely entertaining frame as a moral to the story:
Chalk up another win for excess deregulation
Tie this firmly around Bush's neck, and McCain goes down right with him.
Like a rock.
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PS: Looks like the "net capital rule" is now a hot blogging topic.